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d. Should the machine be purchased? Explain your answer.

d. Should the machine be purchased? Explain your answer.

Essentials Of Investments
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
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Please answer just part D

**Question: New Project Analysis** You need to evaluate a proposal to purchase a new milling machine. The base price is $135,000, with additional shipping and installation costs of $8,000. The machine falls into the MACRS 3-year class and is expected to be sold after 3 years for $94,500. Applicable depreciation rates are 33%, 45%, 15%, and 7%, as detailed in Appendix 12A. The project requires a $5,000 increase in net operating working capital (increased inventory minus increased accounts payable). There will be no effect on revenues, but pretax labor costs will decline by $52,000 annually. The marginal tax rate is 35%, and the weighted average cost of capital (WACC) is 8%. Additionally, $4,500 was spent last year to investigate the machine's feasibility. **Questions:** a. How should the $4,500 spent last year be handled? b. What is the initial investment outlay for the machine for capital budgeting purposes, i.e., what is the Year 0 project cash flow? c. What are the project's annual cash flows during Years 1, 2, and 3? d. Should the machine be purchased? Explain your answer.
Transcribed Image Text:**Question: New Project Analysis** You need to evaluate a proposal to purchase a new milling machine. The base price is $135,000, with additional shipping and installation costs of $8,000. The machine falls into the MACRS 3-year class and is expected to be sold after 3 years for $94,500. Applicable depreciation rates are 33%, 45%, 15%, and 7%, as detailed in Appendix 12A. The project requires a $5,000 increase in net operating working capital (increased inventory minus increased accounts payable). There will be no effect on revenues, but pretax labor costs will decline by $52,000 annually. The marginal tax rate is 35%, and the weighted average cost of capital (WACC) is 8%. Additionally, $4,500 was spent last year to investigate the machine's feasibility. **Questions:** a. How should the $4,500 spent last year be handled? b. What is the initial investment outlay for the machine for capital budgeting purposes, i.e., what is the Year 0 project cash flow? c. What are the project's annual cash flows during Years 1, 2, and 3? d. Should the machine be purchased? Explain your answer.
**Step 1** **MACRS Depreciation** is a method of reduction in book value of tangible fixed assets at an accelerated pace. Most of the value of property, plant, and equipment is depreciated in initial years. Only a certain small amount of depreciation remains for later years. **Step 2 Part a** The amount of $4,500 spent last year on investigation of feasibility of machine should be treated as a **period cost** and be charged in the statement of profit and loss of previous year itself. It can't be denominated as a product cost because such cost is not directly or indirectly related with the production process if such machinery purchasing decision is not made. **Step 3 Part b** The initial investment outlay for the purchase of machinery at time = 0 shall be the purchase price of machinery and the additional expenditure incurred on it to make it come to a working platform. *Initial Investment Outlay = Purchase Price of Machine + Shipping and installation cost* = $135,000 + $8,000 = $143,000 **Step 4 Part c** The details include a table showing the financial particulars for Year 1, Year 2, and Year 3. - **Cost Savings on Labor Costs:** $52,000 each year. - **Less: increase in operating cash flows:** $(5,000) each year. - **Less: Depreciation:** - Year 1: $(16,005) - Year 2: $(21,825) - Year 3: $(7,275) - **Net Profit before taxes:** - Year 1: $30,995 - Year 2: $25,175 - Year 3: $39,725 - **Less: Taxes @ 35%:** - Year 1: $(10,848.25) - Year 2: $(8,811.25) - Year 3: $(13,903.75) - **Cash Flows:** - Year 1: $20,146.75 - Year 2: $16,363.75 - Year 3: $25,821.25
Transcribed Image Text:**Step 1** **MACRS Depreciation** is a method of reduction in book value of tangible fixed assets at an accelerated pace. Most of the value of property, plant, and equipment is depreciated in initial years. Only a certain small amount of depreciation remains for later years. **Step 2 Part a** The amount of $4,500 spent last year on investigation of feasibility of machine should be treated as a **period cost** and be charged in the statement of profit and loss of previous year itself. It can't be denominated as a product cost because such cost is not directly or indirectly related with the production process if such machinery purchasing decision is not made. **Step 3 Part b** The initial investment outlay for the purchase of machinery at time = 0 shall be the purchase price of machinery and the additional expenditure incurred on it to make it come to a working platform. *Initial Investment Outlay = Purchase Price of Machine + Shipping and installation cost* = $135,000 + $8,000 = $143,000 **Step 4 Part c** The details include a table showing the financial particulars for Year 1, Year 2, and Year 3. - **Cost Savings on Labor Costs:** $52,000 each year. - **Less: increase in operating cash flows:** $(5,000) each year. - **Less: Depreciation:** - Year 1: $(16,005) - Year 2: $(21,825) - Year 3: $(7,275) - **Net Profit before taxes:** - Year 1: $30,995 - Year 2: $25,175 - Year 3: $39,725 - **Less: Taxes @ 35%:** - Year 1: $(10,848.25) - Year 2: $(8,811.25) - Year 3: $(13,903.75) - **Cash Flows:** - Year 1: $20,146.75 - Year 2: $16,363.75 - Year 3: $25,821.25
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